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European heads of state agreed on a €109 bn second financial package for Greece today. About one-third of the financing will be covered by debt swaps or rollovers by private bondholders. Aside from improving the terms of existing multilateral loans, the leaders also agreed to expand the European Financial Stability Facility’s mandate, including authority to buy bonds on the secondary market. Ahead of the summit, bond and CDS spreads rose on heightened concerns of a systemic crisis, and Euribor rates continued to rise following recent policy interest rate hikes (to stem inflation). A deal on raising the U.S. debt limit remains elusive. If U.S. sovereign debt were to be downgraded from its top-notch rating, implications for global financial markets and growth could be significant in the face of tighter liquidity conditions. Notably, market confidence in U.S. Treasuries remains strong, which rallied earlier this week on heightened Euro Area tensions, and as White House and Congressional leaders resumed talks on raising the debt ceiling. Recovery of industrial production to pre-crisis trends lags in three-of-six developing regions. Among lagging regions, ECA appears the most vulnerable to shocks that might stem from Europe or the United State, given still large balance sheet adjustments and extensive linkages to the Euro Area.

Ahead of today’s emergency summit in Brussels, bond and CDS spreads rose on growing concerns of contagion from Greece, while euro interbank offer rates (Euribor) continued their upward trend. While Euribor rates (that banks charge each other for €-loans) remain below pre-crisis levels (3-mos. averaged 4.7% in 1H-2008), they have inched upward since mid-2010, as the debt crisis has intensified and the euro softened, and have diverged increasingly from $US-Libor rates. Recently, Euribor rates also increased in response to ECB policy rate-hikes in June and July to stem inflationary pressures. And, Euribor rates rose after last week’s release of the European Banking Authority’s 2011 stress tests on 91 EU banks (accounting for over 65% of EU-bank assets). Eight banks failed outright, while another 16 were found to have low capital in the event of a negative shock.

S&Ps and Moody’s credit rating agencies cut the ratings outlook for U.S. sovereign debt from stable to negative. S&P warned that raising the U.S. debt-limit would be insufficient and that the final plan must deal credibly with medium-term fiscal issues to prevent a downgrade. Such downgrade would likely lead to higher long-term interest rates, adversely affecting U.S. fiscal and debt positions, as well as domestic-and foreign debt-instruments benchmarked to U.S. Treasuries. Debt dynamics would deteriorate. Investors holding U.S. public debt ($14.3 trn outstanding or 93% of U.S. GDP) could face losses, including foreigners holding $4.5 trn. Large losses could prompt foreign reserve and portfolio adjustment. Banks’ Tier-1 capital would need to be rebalanced to meet regulatory standards. And, credit risk premiums for other U.S. and foreign borrowers could rise, while tighter liquidity could create headwinds to real sector growth.

Developing country output in aggregate has risen to levels consistent with pre-crisis trend growth, but this masks marked differences across regions. Significant gaps remain in Europe and Central Asia and the Middle East and North Africa, where output is 15.3% and 21.4%, respectively, below what might have been expected had there been no financial crisis and global recession, and no political turmoil in the Middle East and North Africa. Within-region production performance also varies widely, reflecting effects of recent political turmoil in North Africa, as well as unsustainably high pre-crisis growth rates and severity of the adjustment in European and Central Asian economies. For a small subset of Sub-Saharan African countries for which data is available, the estimated gap is close to 9%. Gaps have already closed in Latin America, East- and South Asia.